Non-trading portfolios

Management of non-trading interest rate risk

Most material non-trading interest rate risks, the largest items being those arising from the Global Wealth Management & Business Banking Business Group, are transferred from the originating business units to one of the two centralized interest rate risk management units, Treasury, which is part of Corporate Center, or the Investment Bank’s Cash and Collateral Trading unit (CCT). These units manage the risks on an integrated basis to exploit the full netting potential across risks from different sources.

Risks from long-term Swiss franc transactions with fixed maturities are transferred to Treasury by individual back-to-back transactions. Risks from all fixed maturity, short-term Swiss franc and all non-Swiss franc transactions are generally transferred to CCT. Client current and savings accounts and many other products of Global Wealth Management & Business Banking have no contractual maturity date or direct market-linked rate, and their interest rate risk cannot be transferred by simple back-to-back transactions. Instead, they are transferred on a pooled basis via “replication portfolios – portfolios of revolving transactions between the originating business unit and Treasury at market rates designed to approximate the average cash flow and re-pricing behavior of the pooled client transactions. The originating business units are thus immunized as far as possible against market interest rate movements, but retain and manage their product margins, while Treasury acquires market-based interest rate positions that can be managed within its approved limits. The structure and parameters of the replication portfolios are based on long-term market observations and client behavior and are reviewed periodically.

A significant amount of interest rate risk also arises from non-business related balance sheet items, such as the financing of bank property and equity investments in associated companies. These risks are generally transferred to Treasury through replicating portfolios, the replication in this case being designed to approximate the mandated funding profile. Similarly, our own equity is represented in the treasury book in the form of equity replicating portfolios which reflect the investment profile defined by senior management.

In addition to the standard portfolio measures (VaR and stress loss) three key risk measures are applied to the interest rate risks managed by Treasury:

– Interest rate sensitivity, which expresses the impact of a one basis point (0.01%) parallel rise in interest rates on the fair value (net present value) of the interest rate positions

– Economic value sensitivity, which measures the potential change in fair value of Treasury’s interest rate positions resulting from a large instantaneous shock to interest rates

– Net interest income at risk, which is defined as the potential change in net interest income resulting from adverse movements in interest rates over the next twelve months.

Interest rate sensitivity is a simple unit measure of sensitivity, which does not, in itself, provide an indication of potential loss. By contrast, the economic value sensitivity and net interest income at risk measures provide different, but complementary, views of potential loss from interest rate risk. Economic value sensitivity provides a long-term view covering the whole book, since it takes into account the present value of all future cash flows generated from existing balance sheet positions. Net interest income at risk, on the other hand, considers only the re-pricing effect from positions maturing over the next twelve months, and thus provides a shorter-term view but one consistent with the accounting basis (amortized cost). In all three measures we assess the exposure both including and excluding the replication portfolio representing our equity (but always including the assets in which the equity is invested). When the replication portfolio is excluded, the exposure under all three measures is greater.

To the extent that Treasury needs to hedge its consolidated positions and exposures, it deals with the Investment Bank’s trading units, which are the sole interface to the external markets for both cash and derivative transactions.

Non-trading interest rate risk development

The equity held by the parent bank is invested predominantly in Swiss francs, but since 2002 the investment of equity at the overall Group level has been diversified into a portfolio of major currencies, in order to reflect the significant business activities denominated in foreign currencies. Accordingly, the consolidated equity, which includes the equity of subsidiaries, is invested not only in Swiss francs but also in US dollars and, to a lesser extent, euro and UK sterling. At 31 December 2005 the Swiss franc portfolio had an average duration of approximately 3.3 years and an interest rate sensitivity of CHF 7.48 million per basis point. For the US dollar portfolio, the duration was 4.8 years and its sensitivity CHF 8.31 million per basis point. For the euro portfolio the duration was 3.3 years and its sensitivity CHF 0.52 million per basis point and for the UK sterling portfolio the duration was 3.2 years and its sensitivity CHF 0.54 million per basis point.

The interest rate sensitivity of these investments is directly related to the chosen investment duration. Investing in significantly shorter maturities would lead to a reduction in the apparent interest rate sensitivity and economic value sensitivity of our treasury positions (excluding the equity itself), but would lead to higher net interest income at risk and to higher volatility in our actual interest earnings.

The first table on the next page shows the interest rate sensitivity of the Treasury book overall interest rate risk positions on 31 December 2005. The first total is the sensitivity including the equity replicating portfolio, while the final total, which is significantly larger, excludes this portfolio.

The second table on the next page shows the change in risk under the economic value sensitivity and net interest income at risk measures between 31 December 2003 and 31 December 2005.

The net interest income at risk figure shown is the worst case among various interest rate scenarios that have been analyzed, and results from an assumed downward interest rate shock (parallel shift) of 200 basis points. On 31 December 2005, the difference in the projected outcome in this scenario from that projected in a constant market rate scenario represented a reduction of CHF 386 million in the year’s total net interest income, compared with a reduction of CHF 321 million on 31 December 2004.

Economic value sensitivity shows the effect of a 100 basis point adverse interest rate shock. On 31 December 2005, a 100 basis point upward shock of interest rates would have led to a CHF 1,439 million decline in fair value, compared with an exposure of CHF 1,214 million to the same scenario on 31 December 2004.